By Andre Kalinowski, founder at blockchain monitoring platform PARSIQ
Being able to monitor and query public blockchains is one of the fundamental properties of cryptocurrencies. Publicly verifiable transactions are what proves that a transfer of value occurred. Even in so-called privacy coins, there still needs to be a mechanism to prove value has been moved from one address to another.
The first block explorers were basic, used to verify a transaction had been added to the blockchain and not much more. The latest generation of blockchain monitoring such as PARSIQ offers something different. They are helping to make crypto safer, reduce market manipulation and increase transparency.
1. Making Crypto Safer by Tracking Stolen Funds
There have been plenty of well-publicized hacks in recent years but it’s getting increasingly hard for the criminals to get away with the crime. This is because most cryptocurrency transactions are not completely anonymous, they’re merely ‘pseudonymous’, so once identified, stolen funds can be tracked, even when they are split up and sent to different addresses.
Taking Bitcoin as an example, a Bitcoin address has no name or identity directly attached to it, yet if someone has knowledge of the connection between you and an address then every transaction you’ve made to and from it is there to be seen on the blockchain.
This means that as soon as the funds are sent to an exchange, with the intention to convert the funds into fiat currencies, they can be frozen and recovered. In addition, once bitcoins are sent to a crypto exchange, a paper trail is created that can be linked to an individual. This is because every account on an exchange should – theoretically at least – be subject to KYC (Know Your Customer), and therefore have the ability to be tracked back to a particular person.
Even without sending cryptocurrencies to an exchange, so-called Blockchain forensics has become big business both in the law enforcement and private sectors in recent years, and specialist techniques can be used to trace movements.
2. Democratizing Information
Market manipulation has long been a problem for cryptocurrencies. Cryptocurrency trading doesn’t have the same level of regulatory oversight as traditional markets. Some of the more common practices of market manipulation are:
- Spoofing — this is where a large order is placed to create the illusion of market optimism or pessimism, but it gets cancelled before the trade is filled.
- Front-running — this is the act of getting advance knowledge of a trade that will influence the price, and taking advantage of that knowledge – a type of insider trade.
- Wash trading —this is where a market participant trades with itself in order to drive the price up or down, or just create the illusion of trading volume. Most wash trading is executed by automated bots, it’s sometimes used by exchanges to artificially inflate their daily trading volumes.
These issues are made worse by the fact that crypto market volumes are small in comparison with traditional markets — therefore small manipulations can have a large impact, especially outside of the top few cryptocurrencies.
However, because blockchains are completely open, the movement of large amounts of funds to exchanges can be tracked and used to anticipate trades. By reacting quickly to these moves, the information can be used to reduce the impact of big trading events, or to take advantage of the resulting volatility of cryptocurrency markets.
3. Utilize the Mempool to Provide an Early Warning System
The Mempool – which is short for Memory Pool – is a holding area for pending transactions which are waiting to be added to the blockchain by the miners.
When a transaction is transmitted to a blockchain network it first must get verified by all of the nodes which run the network. Once it passes verification, it sits inside a node’s “Unconfirmed Transactions” database, otherwise known as the Mempool. The transaction waits there until a miner picks it up and includes it in the next block.
The Mempool is often considered to be the blockchain’s backlog, it’s also where any scaling problems manifest itself – if the network can’t keep up, the Mempool will keep queuing transactions. This the reason Bitcoin forked into Bitcoin and Bitcoin Cash in August 2017 - Bitcoin Cash increased the blocksize in order to prevent potential backlogs and delays in the network.
If something significant is happening, such as a large amount of crypto going to an exchange, the Mempool is where you’ll see it first. It’s crypto’s early warning system, and we’re on the cusp of being able to use it to give extra level of insights into trading activities, alert for crypto hacks, or predict high trading volumes and potential volatility.
Although blockchains are - by their nature - open for everyone to see, the transparency is clouded by size and complexity. To date, there has been a lack of sophisticated tools that have the automation and deep analytics necessary to perform monitoring of blockchain at scale and in real-time. This has meant that a small number of bad actors have been able to manipulate it to their advantage.
However, a new generation of tools are coming to the market. These tools will make crypto safer, they will reduce the volatility of cryptocurrencies, and reduce manipulation. It’s another step towards opening up crypto, and encouraging widespread adoption.